Will Passive Save Active?

According to David F. Lafferty, CFA®, Senior Vice President – Chief Market Strategist at NGAM, the pressures exerted by passive indexing are forcing active managers to tackle longstanding sources of inefficiency and underperformance. By setting more appropriate fees and weeding out closet indexers, active strategies should rise in the competitive rankings.

Indexing Raises the Bar

This month we’re taking a break from global economics and
capital markets for several reasons. First, our views have been
well-covered in this space in recent months. That is, that risk
assets will continue to grind higher as long as the synchronized
global expansion remains on track. Investors should temper
their expectations, however, as valuations across stocks,
sovereign bonds, and credit remain elevated. Simply put,
fundamental strength will exert upward pressure on assets, but
the upside is probably limited longer term because no broad
asset classes are cheap. Second, little has changed in the big
picture over the recent months. The global expansion, slow
normalization from central banks, the on-again-off-again love
affair with US tax reform, growing geopolitical risk, and
challenging valuations still define the backdrop for global
investors.

This month, instead of a market rehash, we’ll turn to the everpopular
active vs. passive debate.

Our objective is not to argue
that one is better than the other – they both have merit within
a diversified portfolio of strategies. Instead, we’ll explore how
the growth in indexing is (paradoxically) forcing active
managers to up their game – a positive development for
investors of all stripes.

Active Adaptation

Times are tough for active managers. Regulation, transparency,
and cost sensitivity have conspired to shift trillions of dollars
from active investment strategies to passive indexing. By most
accounts, the outlook for active investing is challenged, as
investors are losing patience with active managers’ prolonged
streak of underperforming the major indexes. In addition, many
of these managers continue to charge fees that are significantly
higher than those of the passive alternatives. After 35+ years of
beta-driven returns generating abnormally high profit margins
across the industry, the combination of charging more and
delivering less finally looks unsustainable.

These are strong headwinds. While active managers have
always competed against each other, they have never had to
confront a threat of this magnitude. But in a strange irony, the
pressures emanating from cheap passive strategies may
ultimately save the active management industry. As Darwin
demonstrated, the most adaptable species are the ones that
ultimately survive. In this case, passive investing is forcing
changes to active management that are long overdue. We see
five trends that should bode well for active managers who are
best able to adapt in the coming years.

#1: Lower Fees, Better Performance

First, and most obvious, indexing is forcing active managers to
reassess the competitiveness of their fees. Going forward,
active managers will have to better align their fees with their
ability to generate excess return. These downward adjustments
will, by definition, improve net performance (ceteris paribus).
Regulatory changes also play a role. Directives like RDR in the
UK and proposed fiduciary rules in the US are forcing fund
buyers to purchase lower-cost share classes with many of the
extraneous expenses eliminated. In the US, high fee B-shares
died several years ago, while sales of the once popular C-shares
are moribund. The truth is that many of these share classes had
total expense ratios high enough that long-term
outperformance was unlikely. The industry’s movement toward
lower cost appears well under way.

A recent study by FUSE
Research Network notes that average fees for active equity
funds have fallen from 0.92% to 0.75% over the past ten years
– a 18% drop. As active managers continue to cut fees and
investors demand more stripped down share classes, fewer
structural laggards will be left in the active universe.

#2: Lean and Mean

On top of improved performance, a closer eye on costs could
bring additional benefits. We believe lower fee revenue will
result in an era of increased discipline and efficiency for active
managers. Over the years, high profit margins across the
industry have allowed the focus of active managers to wander.

Many overinvested in areas of the business unrelated to
generating alpha, but as margins shrink, the days of industry
giveaways and boondoggles are likely numbered.

Revenue
pressures will force active managers to streamline and focus
squarely on activities that seek alpha. They may increasingly
turn to new technologies to reduce labor costs and seek
performance consistency. If adopted, smarter trading and more
efficient use of quantitative techniques should lead to lower
expenses and more competitive returns.

#3: Death of the Closet Indexers

A greater focus on generating excess return will naturally drive
managers to create more differentiated portfolios. As early as
the 1980s, institutions began to recognize that portfolios could
be made more efficient by separating cheap beta from
expensive alpha. Today, even retail investors understand the
perils of benchmark hugging and overpaying for beta, and are
gradually forcing the closet indexers out of business. As
investors barbell between low fee beta and higher fee alpha,
the active funds that remain will be more concentrated and
have less benchmark overlap. While this “high active share”
alone may not be sufficient to generate excess return, it is
certainly a necessary condition.

As a result, fewer strategies that are structurally unable to outperform their expense drag
will remain in the databases. Like lower fees, this third trend will
also improve the relative performance of active managers
compared to their benchmarks.

#4: Is Anyone Paying Attention to Fundamentals?

A fourth consequence of the growth in passive investing is an
increasing misallocation of capital. Counterintuitively, indexing
may be creating greater opportunities for active managers as
more capital is put on autopilot without regard to asset quality.
Today, the majority of indexed assets are simply allocated
based on market capitalization (for stocks) or issuance size (for
bonds). No distinction is made regarding companies’
fundamentals, valuation, risk, or governance practices. While
investors can expect markets to remain reasonably efficient,
the surge in indexed assets can create larger pockets of
mispriced securities. Again, there is no guarantee that the
majority of active managers will be able to systematically take
advantage of these pricing inefficiencies. However, for active
managers skilled enough to capitalize on it, opportunities to
generate alpha are likely to increase.

#5: The Perils of Autopilot

Finally, some active strategies stand to gain from one of
indexing’s inherent weaknesses: the inability to manage risk.
The major market-cap and issuance weighted indexes are fully
invested at all times and provide pure beta, delivering all of
what the market provides, good and bad. Since 2009 this has
been a boon for passive strategies, as global stocks have risen
while declining interest rates bolstered bonds. But at some
point the bear will return, and when it does, investors will
rediscover the darker side of holding assets on autopilot. While
there is no guarantee that active strategies on average will
outperform the indexes in the next big selloff, these managers
at least have the ability to de-risk during periods of trouble.

In
the next bear market, many investors who have been spoiled
by full upside participation will come to realize the pain of full
downside exposure. As with planes and self-driving cars,
enthusiasm for autopilot may wane after the first crash.

This
may be when investors develop new respect for the segment of
active strategies that can offer some downside protection that
the indexes, by their very nature, can’t provide.

Wake-Up Call

None of these factors, individually or in aggregate, insures that
the average active manager will beat the index or outperform
net of fees. However, the pressures exerted by passive indexing
are forcing active managers to tackle longstanding sources of
inefficiency and underperformance. By setting more
appropriate fees and weeding out closet indexers, active
strategies should rise in the competitive rankings. Moreover,
the wake-up call of the next bear market will force investors to
be more discerning about the quality of the assets they own,
pushing many of them towards strategies that can better
manage risk.

Instead of complaining, active managers should
embrace the changes occurring in the asset management
industry. In the long run, the competitive pressures of passive
indexing may save active management.

Focus

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